Reading 71: guidance for standards I-VII

Question 1

In situations where the laws of a member or candidate’s country of residence, the local laws of regions where the member or candidate does business, and the Code and Standards specify different requirements, the member or candidate must abide by:
local law or the Code and Standards, whichever is stricter.
the Code and Standards or his country’s laws, whichever are stricter.
the strictest of local law, his country’s laws, or the Code and Standards.

Answer 1

To comply with Standard I(A) Knowledge of the Law, a member must always abide by the strictest applicable law, regulation, or standard. (Module 71.1, LOS 71.a, 71.b, 71.c)

Question 2

According to the Standard on independence and objectivity, members and candidates:
may accept gifts or bonuses from clients.
may not accept compensation from an issuer of securities in return for producing research on those securities.
should consider credit ratings issued by recognized agencies to be objective measures of credit quality.

Answer 2

Gifts from clients are acceptable under Standard I(B) Independence and Objectivity, but the Standard requires members and candidates to disclose such gifts to their employers. Standard I(B) allows issuer-paid research as long as the analysis is thorough, independent, unbiased, and has a reasonable and adequate basis for its conclusions, and the compensation from the issuer is disclosed. Members and candidates should consider the potential for conflicts of interest inherent in credit ratings and may need to do independent research to evaluate the soundness of these ratings. (Module 71.1, LOS 71.a, 71.b, 71.c)

Question 3

Bill Cooper finds a table of historical bond yields on the website of the U.S. Treasury that supports the work he has done in his analysis and includes the table as part of his report without citing the source. Has Cooper violated the Code and Standards?
Yes, because he did not cite the source of the table.
Yes, because he did not verify the accuracy of the information.
No, because the table is from a recognized source of financial or statistical data.

Answer 3

According to Standard I(C) Misrepresentation, members and candidates must cite the sources of the information they use in their analysis, unless the information is factual data (as opposed to analysis or opinion) from a recognized financial or statistical reporting service. The U.S. Treasury is one example of a recognized source of factual data. (Module 71.2, LOS 71.a, 71.b, 71.c)

Question 4

Which of the following statements about the Standard on misconduct is most accurate?
Misconduct applies only to a member or candidate’s professional activities.
Neglecting to perform due diligence when required is an example of misconduct.
A member or candidate commits misconduct by engaging in any illegal activity.

Answer 4

Failing to act when required by one’s professional obligations, such as neglecting to perform due diligence related to an investment recommendation, violates Standard I(D) Misconduct. Acts a member commits outside his professional capacity are misconduct if they reflect poorly on the member or candidate’s honesty, integrity, or competence (e.g., theft or fraud).Violations of the law that do not reflect on the member or candidate’s honesty, integrity, or competence (e.g., an act related to civil disobedience) are not necessarily regarded as misconduct. (Module 71.2, LOS 71.a, 71.b, 71.c)

Question 5

Ed Ingus, CFA, visits the headquarters and main plant of Bullitt Company and observes that inventories of unsold goods appear unusually large. From the CFO, he learns that a recent increase in returned items may result in earnings for the current quarter that are below analysts’ estimates. Based on his visit, Ingus changes his recommendation on Bullitt to “Sell.” Has Ingus violated the Standard concerning material nonpublic information?
Yes.
No, because the information he used is not material.
No, because his actions are consistent with the mosaic theory.

Answer 5

The statement from the CFO about the current quarter’s earnings is material nonpublic information. Ingus violated Standard II(A) Material Nonpublic Information by acting or causing others to act on it. (Module 71.3, LOS 71.a, 71.b, 71.c)

Question 6

Green Brothers, an emerging market fund manager, has two of its subsidiaries simultaneously buy and sell emerging market stocks. In its marketing literature, Green Brothers cites the overall emerging market volume as evidence of the market’s liquidity. As a result of its actions, more investors participate in the emerging markets fund. Green Brothers most likely:
did not violate the Code and Standards.
violated the Standard regarding market manipulation.
violated the Standard regarding performance presentation.

Answer 6

The intent of Green Brothers’ actions is to manipulate the appearance of market liquidity in order to attract investment to its own funds. The increased trading activity was not based on market fundamentals or an actual trading strategy to benefit investors. It was merely an attempt to mislead market participants in order to increase assets under Green Brothers’ management. The action violates Standard II(B) Market Manipulation. (Module 71.3, LOS 71.a, 71.b, 71.c)

Question 7

Cobb, Inc., has hired Jude Kasten, CFA, to manage its pension fund. The client(s) to whom Kasten owes a duty of loyalty are:
Cobb’s management.
the shareholders of Cobb, Inc.
the beneficiaries of the pension fund.

Answer 7

Standard III(A) Loyalty, Prudence, and Care specifies that for the manager of a pension or trust, the duty of loyalty is owed to the beneficiaries, not to the individuals who hired the manager. (Module 71.4, LOS 71.a, 71.b, 71.c)

Question 8

Which of the following actions is most likely a violation of the Standard on fair dealing?
A portfolio manager allocates IPO shares to all client accounts, including her brother’s fee-based retirement account.
An investment firm routinely begins trading for its own account immediately after announcing recommendation changes to clients.
After releasing a general recommendation to all clients, an analyst calls the firm’s largest institutional clients to discuss the recommendation in more detail.

Answer 8

The firm must give its clients an opportunity to act on recommendation changes. Firms can offer different levels of service to clients as long as this is disclosed to all clients. The largest institutional clients would likely be paying higher fees for a greater level of service. The portfolio manager’s brother’s account should be treated the same as any other client account. (Module 71.4, LOS 71.a, 71.b, 71.c)

Question 9

The Standard regarding suitability most likely requires that:
an advisor must analyze an investment’s suitability for the client prior to recommending or acting on the investment.
a member or candidate must decline to carry out an unsolicited transaction that she believes is unsuitable for the client.
when managing a fund to an index, a manager who is evaluating potential investments must consider their suitability for the fund’s shareholders.

Answer 9

According to Standard III(C) Suitability, a member or candidate who is in an advisory relationship with a client is responsible for analyzing the suitability of an investment for the client before taking investment action or making a recommendation. If a member or candidate believes an unsolicited trade is unsuitable for a client, the appropriate action is to discuss the trade with the client. The advisor may follow her firm’s policies for obtaining client approval if the requested trade would not affect the risk and return of the client’s portfolio materially. If the trade would have a material effect, the advisor should discuss with the client whether the IPS needs to be updated. When managing a fund to an index or stated mandate, the manager is responsible for ensuring that potential investments are consistent with the fund’s mandate. Suitability for individuals would be a concern for an advisor who recommends the fund to clients, but not for the manager of the fund. (Module 71.5, LOS 71.a, 71.b, 71.c)

Question 10

Which of the following is most likely a recommended procedure for complying with the Standard on performance presentation?
Exclude terminated accounts from past performance history.
Present the performance of a representative account to show how a composite has performed.
Consider the level of financial knowledge of the audience to whom the performance is presented.

Answer 10

Recommendations stated in Standard III(D) Performance Presentation include considering the sophistication and knowledge of the audience when presenting performance data. Other recommendations are to include terminated accounts in past performance history; to present the performance of a composite as a weighted average of the performance of similar portfolios, rather than using a single representative account; and to maintain the records and data that were used to calculate performance. (Module 71.5, LOS 71.a, 71.b, 71.c)

Question 11

The CFA Institute Professional Conduct Program (PCP) has begun an investigation into Chris Jones, a Level II CFA candidate, and a number of his CFA charterholder colleagues. Jones has access to confidential client records that could be useful in clearing his name and wishes to share this information with the PCP. Which of the following most accurately describes Jones’s duties with regard to preservation of confidentiality?
Sharing the confidential information with the PCP would violate the Standards.
The Standards encourage, but do not require, that Jones support the PCP investigation into his colleagues.
Jones may share confidential information about former clients with the PCP but may not share confidential information about current clients.

Answer 11

Members and candidates are required to cooperate with PCP investigations into their own conduct and encouraged to cooperate with PCP investigations into the conduct of others. Sharing confidential information with the PCP is not a violation of Standard III(E) Preservation of Confidentiality. Any client information shared with the PCP will be kept in strict confidence. Standard III(E) states that members and candidates are required to maintain confidentiality of client records even after the end of the client relationship. (Module 71.5, LOS 71.a, 71.b, 71.c)

Question 12

Connie Fletcher, CFA, works for a small money management firm that specializes in pension accounts. Recently, a friend asked her to act as an unpaid volunteer manager for the city’s street sweep pension fund. As part of the position, the city would grant Fletcher a free parking space in front of her downtown office. Before Fletcher accepts, she should most appropriately:
do nothing because this is a volunteer position.
inform her current clients in writing and discuss the offer with her employer.
disclose the details of the volunteer position to her employer and obtain written permission from her employer.

Answer 12

According to Standard IV(A) Loyalty, members and candidates are expected to act for the benefit of their employer and not deprive the employer of their skills. Fletcher is performing work similar to the services that her employer provides. Although the position is a volunteer position, Fletcher will receive compensation in the form of a free parking space. In light of the circumstances, Fletcher must disclose the details of the position to her employer and get written permission before accepting the volunteer position. (Module 71.6, LOS 71.a, 71.b, 71.c)

Question 13

Sarah Johnson, a portfolio manager, is offered a bonus directly by a client if Johnson meets certain performance goals. To comply with the Standard that governs additional compensation arrangements, Johnson should:
decline to accept a bonus outside of her compensation from her employer.
disclose this arrangement to her employer in writing and obtain her employer’s permission.
disclose this arrangement to her employer only if she actually meets the performance goals and receives the bonus.

Answer 13

Johnson should disclose her additional compensation arrangement in writing to her employer and obtain her employer’s written consent before accepting this offer, in accordance with Standard IV(B) Additional Compensation Arrangements. (Module 71.6, LOS 71.a, 71.b, 71.c)

Question 14

A member or candidate who has supervisory responsibility:
should place particular emphasis on enforcing investment-related compliance policies.
is responsible for instructing those to whom he has delegated authority about methods to detect and prevent violations of the law and the Code and Standards.
has complied with the Standards if she reports employee violations to upper management and provides a written warning to the employee to cease such activities.

Answer 14

Members or candidates may delegate supervisory duties to subordinates but remain responsible for instructing them about how to detect and prevent violations. Reporting the violation and warning the employee are not sufficient to comply with Standard IV(C) Responsibilities of Supervisors. The supervisor must also take steps to prevent further violations while she conducts an investigation, such as limiting the employee’s activity or increasing her monitoring of the employee. Supervisors should enforce investment-related and non-investment-related policies equally. (Module 71.6, LOS 71.a, 71.b, 71.c)

Question 15

Which of the following actions is a required, rather than recommended, action under the Standard regarding diligence and a reasonable basis for a firm’s research recommendations?
Compensate analysts based on a measure of the quality of their research.
Review the assumptions used and evaluate the objectivity of third-party research reports.
Have a policy requiring that research reports and recommendations have a basis that can be substantiated as reasonable and adequate.

Answer 15

Standard V(A) Diligence and Reasonable Basis requires analysts who use third-party research to review its assumptions and evaluate the independence and objectivity of the research. The other choices are recommended procedures for compliance with the Standard. (Module 71.7, LOS 71.a, 71.b, 71.c)

Question 16

Claire Marlin, CFA, manages an investment fund specializing in foreign currency trading. Marlin writes a report to investors that describes the basic characteristics of her strategy, which is based on an expected appreciation of the euro relative to other major currencies. Marlin shows the projected returns from the strategy if the euro appreciates less than 5%, between 5% and 10%, or more than 10%, while clearly stating that these forecasts are her opinion. Has Marlin violated the Standard related to communication with clients?
Yes, because she did not include a scenario in which the euro depreciates.
No, because she disclosed the basic characteristics of the investment.
No, because she distinguished fact from opinion and discussed how the strategy may perform under a range of scenarios.

Answer 16

Standard V(B) Communication with Clients and Prospective Clients requires that members and candidates communicate the risk associated with the investment strategy used and how the strategy is expected to perform in a range of scenarios. These scenarios should include those different from the current trend. Marlin should have discussed how her strategy would perform if the euro depreciates instead of appreciating as she expects. (Module 71.7, LOS 71.a, 71.b, 71.c)

Question 17

If regulations do not specify how long to retain the documents that support an analyst’s conclusions, the Code and Standards recommend a period of at least:
5 years.
7 years.
10 years.

Answer 17

When no other regulatory guidance applies, Standard V(C) Record Retention recommends that records be maintained for a minimum of seven years. (Module 71.7, LOS 71.a, 71.b, 71.c)

Question 18

Daniel Lyons, CFA, is an analyst who covers several stocks including Horizon Company. Lyons’s aunt owns 30,000 shares of Horizon. She informs Lyons that she has created a trust in his name into which she has placed 2,000 shares of Horizon. The trust is structured so that Lyons will not be able to sell the shares until his aunt dies, but may vote the shares. Lyons is due to update his research coverage of Horizon next week. Lyons should most appropriately:
update the report as usual because he is not a beneficial owner of the stock.
advise his superiors that he is no longer able to issue research recommendations on Horizon.
disclose the situation to his employer and, if then asked to prepare a report, also disclose his beneficial ownership of the shares in his report.

Answer 18

Even though the shares are held in trust, Lyons is considered a beneficial owner under Standard VI(A) Disclosure of Conflicts because he has a pecuniary interest in the shares and because has the power to vote the shares. Lyons is obligated to inform his employer of the potential conflict. If Lyons’s employer permits him to continue issuing investment recommendations on the company, Lyons must disclose the existence of a potential conflict in his reports. (Module 71.8, LOS 71.a, 71.b, 71.c)

Question 19

Kate Wilson, CFA, is an equity analyst. Wilson enters two transactions for her personal account. Wilson sells 500 shares of Tibon, Inc., a stock on which her firm currently has a “Buy” recommendation. Wilson buys 200 shares of Hayfield Co. and the following day issues a research report on Hayfield with a “Buy” recommendation. Has Wilson violated the Code and Standards?
No.
Yes, both of her actions violate the Code and Standards.
Yes, but only one of her actions violates the Code and Standards.

Answer 19

Only one of these transactions is a violation. Standard VI(B) Priority of Transactions requires members and candidates to give clients an adequate opportunity to act on a recommendation before trading for accounts in which the member or candidate has a beneficial ownership interest. Members and candidates may trade for their own accounts as long as they do not disadvantage clients, benefit personally from client trades, or violate any regulations that apply. The Standard does not prohibit members and candidates from entering personal transactions that are contrary to what their firms are recommending for clients, as long as the transaction does not violate any of these criteria. (Module 71.8, LOS 71.a, 71.b, 71.c)

Question 20

Hern Investments provides monthly emerging market research to Baker Brokerage in exchange for prospective client referrals and European equity research from Baker. Clients and prospects of Hern are not made aware of the agreement, but clients unanimously rave about the high quality of the research provided by Baker. As a result of the research, many clients with nondiscretionary accounts have earned substantial returns on their portfolios. Managers at Hern have also used the research to earn outstanding returns for the firm’s discretionary accounts. Hern has most likely:
not violated the Code and Standards.
violated the Code and Standards by using third-party research in discretionary accounts.
violated the Code and Standards by failing to disclose the referral agreement with Baker.

Answer 20

According to Standard VI(C) Referral Fees, Hern must disclose the referral arrangement between itself and Baker so that potential clients can judge the true cost of Hern’s services and assess whether there is any partiality inherent in the recommendation of services. (Module 71.8, LOS 71.a, 71.b, 71.c)

Question 21

After writing the Level I CFA exam, Cynthia White goes to internet discussion site CFA Haven to express her frustration. White writes, “CFA Institute is not doing a competent job of evaluating candidates because none of the questions in the June exam touched on Alternative Investments.” White most likely violated the Standard related to conduct as a candidate in the CFA program by:
publicly disputing CFA Institute policies and procedures.
disclosing subject matter covered or not covered on a CFA exam.
participating in an internet forum that is directed toward CFA Program participants.

Answer 21

Standard VII(A) Conduct as Participants in CFA Institute Programs prohibits candidates from revealing which portions of the Candidate Body of Knowledge were or were not covered on an exam. Members and candidates are free to disagree with the policies, procedures, or positions taken by the CFA Institute. The Standard does not prohibit participating in CFA Program-related internet blogs, forums, or social networks. (Module 71.9, LOS 71.a, 71.b, 71.c)

Question 22

After passing all three levels of the CFA exams on her first attempts and being awarded her CFA charter, Paula Osgood is promoting her new money management firm by issuing an advertisement. Which of these statements would most likely violate the Standard related to use of the CFA designation?
“To earn the right to use the CFA designation, Paula passed three exams covering ethics, financial statement analysis, asset valuation, and portfolio management.”
“Paula passed three 6-hour exams on her first attempts and is a member of her local investment analyst society.”
“Because of her extensive training, Paula will be able to achieve better investment results than managers who have not been awarded the CFA designation.”

Answer 22

Standard VII(B) Reference to CFA Institute, the CFA Designation, and the CFA Program prohibits members and candidates from implying superior performance as a result of being a CFA charterholder. Concise factual descriptions of the requirements to obtain the CFA charter are acceptable. Osgood’s statement that she passed the exams on her first attempts is acceptable because it states a fact. (Module 71.9, LOS 71.a, 71.b, 71.c)